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Principal and Income

Principal and Income. Conflict between beneficiary types. Trustee owes duty of impartiality. § 117.008. What does income B want?. What does remainder B want? . History of determining principal and income. Before January 1, 2004 = 1962 version of Uniform Principal and Income Act.

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Principal and Income

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  1. Principal and Income

  2. Conflict between beneficiary types • Trustee owes duty of impartiality. § 117.008. What does income B want? What does remainder B want?

  3. History of determining principal and income • Before January 1, 2004 = 1962 version of Uniform Principal and Income Act. • Beginning January 1, 2004 = 1997 version of Uniform Principal and Income Act. • Many items significantly different from 1962 Act. • Texas made some unique changes. • Chapter 116.

  4. Principal and Income[continued]

  5. Methods of allocating receipts and charging expenses -- § 116.004 • 1. Settlor’s instructions • Specific allocation rules • Trustee’s discretion • Note that following UPIA deemed fair and reasonable to all beneficiaries.

  6. Methods of allocating receipts and charging expenses -- § 116.004 • 2. Trust Code rules

  7. Methods of allocating receipts and charging expenses -- § 116.004 • 3. If no settlor instruction or Trust Code rule, allocate to principal.

  8. Basic Allocation Rules

  9. Basic Allocation Rules • 1. Capital gains = principal • Basis = $10,000 • Sales price = $15,000 • Income = ? • Principal = ? • § 116.161

  10. Basic Allocation Rules • 2. Interest earned = income • CD face value = $10,000 • Interest received = $500 • Income = ? • Principal = ? • § 116.163

  11. Basic Allocation Rules • 3. Rent = Income • House value = $250,000 • Rent received each month = $1,000 • Income = ? • Principal = ? • § 116.162

  12. Basic Allocation Rules • 4. Eminent Domain Award = Principal • House basis = $250,000 • Government pays FMV = $225,000 • Income = ? • Principal = ? • § 116.161

  13. Basic Allocation Rules • 5. Insurance Proceeds = Principal • House basis = $250,000 • House burns • Insurance company pays FMV = $225,000 • Income = ? • Principal = ? • § 116.161

  14. Basic Allocation Rules • 6. Dividends • Cash dividend = income • Stock dividend = principal • Stock split = principal • Stock received because of merger = principal • § 116.151

  15. Basic Allocation Rules • 7. Business & Farm Receipts • Determined according to GAAP (generally accepted accounting principals). • § 116.153

  16. Basic Allocation Rules • 8. Liquidating or “Wasting” Asset • Definition = Asset which goes down in value as it used in an amount greater than depreciation. • Examples = • Note that natural resources have different rules.

  17. Basic Allocation Rules • 8. Liquidating or “Wasting” Asset • Prior Law • Income = receipts up to 5% of asset’s value • Principal = receipts over 5% of asset’s value • Current Law • Income = 10% of each receipt • Principal = 90% of each receipt • § 116.173

  18. Basic Allocation Rules • 8. Liquidating or “Wasting” Asset Example: • Book royalty interest FMV = $100,000 • Royalties received in year = $7,500 • Prior Law • Income = $5,000 • Principal = $2,500 • Current Law • Income = $750 • Principal = 6,750

  19. Basic Allocation Rules • 9. Oil & Gas Royalties • Prior Texas Law • Income = 72.5% • Principal = 27.5% • Uniform Law • Income = 10% • Principal = 90% • Current Texas Law -- § 116.174 • Equitably • If trust owned royalty interest on 1/1/2004, may use prior Texas law. • Following IRS depletion allowances deemed equitable.

  20. Basic Allocation Rules • 10. Timber • Income = timber removed that does not exceed regrowth • Principal = timber removed that exceeds regrowth • Texas -- § 116.175

  21. Basic Allocation Rules • 11. Non-income Earning Property • When sold, all proceeds are principal • Doctrine of “delayed income” which allocated some of the proceeds to income no longer followed. • Texas -- § 116.176

  22. Trustee’s Adjustment Power§ 116.005 • Basic Idea = allow trustee to ignore basic rules under certain circumstances. • Very controversial • Delayed wide-spread adoption of UPIA. • Many states omit or substantially revise. • Example:

  23. Trustee’s Adjustment Power§ 116.005 • Factors trustee must consider: • Nature, purpose, and expected duration of trust • Settlor’s intent. • Identity and circumstances of the beneficiaries

  24. Trustee’s Adjustment Power§ 116.005 • Factors trustee must consider (continued): • Need for liquidity, income, preservation, and appreciation. • Is asset from settlor, used by beneficiary, or a mere investment? • Terms of trust regarding principal invasion and income accumulation.

  25. Trustee’s Adjustment Power§ 116.005 • Factors trustee must consider (continued): • Tax consequences. • Statute has others.

  26. Trustee’s Adjustment Power§ 116.005 • When adjustment not allowed: • Specifically prohibited by settlor (not just a statement of “no adjustment”). • Trustee is a beneficiary. • Trustee would directly or indirectly benefit from the adjustment. • Adverse tax consequences.

  27. Trustee’s Adjustment Power§ 116.005 • No notice to beneficiaries needed • But, some states add this requirement • Court may reverse trustee’s decision to adjust (or not adjust) only if it finds trustee abused its discretion. § 116.006. • Trustee may seek court approval of an adjustment if trustee reasonably believes a beneficiary will object.

  28. Apportionment Timing • Detailed rules exist for apportionment when: • Trust begins (inter vivos and testamentary) • Beneficiaries change • Trust ends • §§ 116.051 through 116.103.

  29. Disbursements • 1. Trustee Compensation • Presumption • Principal = 50% • Income = 50% • But, trustee may allocate in any manner as long as it is consistent with the trustee’s fiduciary duties. • §§ 116.201 & 116.202

  30. Disbursements • 2. Accounting Expenses • Principal = 50% • Income = 50% • §§ 116.201 & 116.202

  31. Disbursements • 3. Ordinary Repairs • Income • § 116.201

  32. Disbursements • 4. Capital Improvements and Extraordinary Repairs • Principal • § 116.204

  33. Disbursements • 5. Debt Payment (including mortgages) • Interest = Income • § 116.201 • Principal = Principal • § 116.202

  34. Disbursements • 6. Insurance Premiums on Principal • Income • § 116.201

  35. Disbursements • 7. Income Taxes • If based on receipts allocated to income = income • If based on receipts allocated to principal = principal • 116.205

  36. Disbursements • 8. Property Taxes • Income • 116.201(3)

  37. Disbursements • 9. Depreciation • Does some income need to be allocated to principal to compensate for depreciation? • Prior law = yes • Current law = trustee’s discretion • 116.203

  38. Unitrust

  39. Unitrust • Basic idea = Current beneficiary receives a fixed percentage of trust’s fair market value each year. • Thus, all beneficiaries want value of trust to increase. • Not concerned about why – income or principal.

  40. Unitrust • Issue = How to set the unitrust rate? • Issue = Can P/I trusts be converted to unitrusts?

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